How to make sure you don’t misclassify employees as independent contractors Featured

8:00pm EDT May 26, 2010

There is no absolute test for determining who is an employee and who is an independent contractor, resulting in confusion among employers and the misclassification of employees.

A number of government agencies have received funding increases specifically to address the issue and the IRS is randomly auditing classifications at 6,000 companies over the next three years. That makes this a good time for employers to review worker classifications and make sure they have it right, says Miriam Rosen, an employment law attorney at McDonald Hopkins LLC.

“Every company needs to take a hard look at who is classified as an employee and who is classified as an independent contractor,” says Rosen.

Smart Business spoke with Rosen about the difficulty of correctly classifying employees and the steps you can take to avoid serious consequences.

Why has this issue become a high priority?

The government has identified this as an issue that is stripping employees of rights by misclassifying them as independent contractors, causing workers to lose out on potential overtime, access to unemployment compensation, health benefits, pensions and other benefits that employees receive. In addition, state and federal governments are strapped for money and they view this as a potential source of revenue. If government agencies can identify workers who are misclassified as independent contractors, this increases the pool of people who are paying taxes and having taxes paid on them, which increases revenue. The U.S. Government Accountability Office has actually estimated that lost revenue from independent contractor misclassification is well in the billions of dollars.

What are the criteria for determining whether a worker is an employee or an independent contractor?

There is no bright line test, and different government agencies use different tests to classify workers. But the basic criterion for classifying a worker as an employee is that the employer controls what that person does and how he or she does it. Examples of control are setting hours, defining how the employee does the work, providing tools to do the job, and providing equipment and space to perform the work.

Independent contractors, on the other hand, control the work themselves, deciding how and where the work is done with their own equipment and tools. The only thing the business gets from them is the end product.

Other factors are whether the workers have some risk of profit or loss, and whether they hold themselves out to other businesses as someone who offers these services.

Why is there so much confusion about classifying employees?

Sometimes the issue of who is controlling the work is not as clear as it seems. With certain professions — such as IT personnel, where the work is often complex — it is hard to evaluate who is really controlling what is done. An employer might think, ‘I am not telling them how to do their jobs.’ But just because you are not making specific decisions does not mean that you are not still controlling the details of the work.

Another source of confusion is that some companies mistakenly assume that temporary employees and independent contractors are interchangeable. An executive may think, ‘We only need that person for a short time. Let’s just get a contractor because it is just a few months.’ However, the fact that it is not a long-term or ‘regular’ position does not automatically make that worker an independent contractor. The company still needs to evaluate the nature of the relationship and who is controlling the work to be done.

Finally, things change. The relationship may initially have been properly classified as an independent contractor status. The company thought this person would provide a specific service of limited duration. But the person turned out to be a great fit with the company, there were other things she could do, so she keeps working, now at the direction of the company. While the relationship changed, the company never changed the classification from independent contractor to employee.

What steps can a company take to stay out of trouble and avoid misclassification?

First, evaluate the status of your workers and review your business relationships to determine if any of your independent contractors are improperly classified.

Also, consult with legal counsel to evaluate whether you truly have an independent contractor relationship. Many companies think that they are protected from misclassification because they have independent contractor agreements in place, but if those agreements are not properly drafted, then it does not really do the company any good. Many independent contractor agreements are just modified employment agreements. A lot of times, both the company and the independent contractor are happy with the arrangement. But if the relationship ends badly and a government agency gets involved, that initial agreement to the arrangement will not be enough to protect the company and the consequences could be significant.

What are the consequences of misclassifying employees?

Misclassification can carry some pretty substantial financial consequences. From an IRS perspective, there are unpaid federal income tax withholdings and liability for Social Security and Medicare contributions. If the Department of Labor is involved, you potentially have the failure to pay overtime and to provide benefits, such as health and pension.

There are also fines and penalties related to all of the above. On top of that, once you draw an agency’s attention to your organization, it will look beyond just one employee; an audit can spread to everyone who might be in the affected class.

Miriam Rosen is an employment law attorney at McDonald Hopkins LLC. Reach her at mrosen@mcdonaldhopkins.com or (248) 220-1342.